Rising rates needn’t poison your portfolio

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Investors were caught off guard when the Fed signaled it would start raising interest rates, but higher rates aren’t necessarily bad for the stock market.

By John Dorfman
Globe Correspondent
July 07, 2013

Let’s get one myth out of the way first: Rising interest rates are not necessarily poisonous to your investment portfolio. But adjustments may be required.

Technology, health care, and certain consumer-goods stocks have withstood rising rates best, according to a historical study I did recently. Utility, energy, and bank stocks have tended to lag when rates are marching up.

Bonds were outside the scope of my study, but now is a good time to lighten up on them. When rates rise, the value of bonds falls. The interest you earn on the bonds might not be enough to offset the capital loss.

Rates and the market

Interest rates affect the economy and the market in several ways. First, low rates encourage borrowing and economic expansion. Second, stocks compete for investors’ money with bonds and other fixed-rate investments. When rates are high, bonds offer fatter yields and higher income to new investors, which can make them look better relative to stocks.

Third, prevailing interest rates are plugged into the formulas analysts use to determine the fair value for a stock. A stream of future profits or dividends is worth more when rates are low.

The traditional wisdom is that rising rates are bad for stocks, but that is only partially true. If rates are high and rising, that can be lethal. Right now, they are rising off a very low base. Rate increases in that situation are often the sign of a recovering economy.

Indeed, the S&P 500, which is a decent measure of the overall US stock market, rose an average of 16 percent during the three years of rising rates covered by my study — 1994, 1998, and 2009.

In the past 13 months, the interest rate on 10-year Treasury bonds has crept up from 1.45 percent to 2.50 percent. But that level is still far below the average for the past 20 years, 4.64 percent.

Why tech excelled

In my study, the best sector in which to seek good returns during periods of rising interest rates was information technology. There are several reasons.

Most successful technology companies are largely self-funding, paying for expansion and research with cash from operations. Many are debt-free or have little debt. If you don’t borrow, rising interest rates don’t pinch you much.

Investors who buy technology stocks are usually looking for growth. They are not weighing the dividend against the interest paid by a bond or certificate of deposit.

Some special circumstances may also have made tech stocks look good in my study. Two of the three study years were in the 1990s, a golden age for technology stocks. The gain on tech stocks as a group in the 1990s was 164 percent, compared to 88 percent for the S&P 500 as a whole.

What to avoid

It stands to reason that utility stocks don’t do well when rates rise. These are favorites of conservative, income-oriented investors, paying regular and dependable dividends. Rising rates on bonds and certificates of deposit mean higher income, drawing the money of conservative investors away from utility shares.

Energy stocks, especially those of big oil companies, also are popular partly for the dividends they pay. And oil and gas drilling requires tons of capital, some of which is typically borrowed at prevailing rates. As rates rise, it becomes more expensive to drill.

Financial stocks are a complex case. For a bank, it is probably easier to borrow at 2 percent and lend at 4 percent than to borrow at 6 percent and lend at 12 percent. Above a certain point, borrowers balk, and it is harder for banks to maintain their profit margins.

The evidence on the effect of rising rates on financial stocks is ambiguous. But in my study they were the third-worst group during periods of rising interest rates. I wouldn’t avoid financial stocks, but I wouldn’t go overboard on them.

The consensus of investors these days seems to be that interest rates will continue to rise in the next year or two. Much as I enjoy going against the crowd, in this case I agree with the consensus.

Assuming rates keep edging up, you don’t necessarily have to say good-bye to profits in the stock market. But you do want to pay attention. Putting your money in the right sectors could make a big difference in your returns.

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